Russia’s missing economy

Vladimir Putin is blaming Europe for Russia’s impending economic decline. In a somewhat incendiary address in April, the President issued a stark warning to his cabinet, warning them to brace themselves – and the country – for a recession. The weak economic outlook in Europe is certainly playing a role in the decline of Russia’s own economy, but there are other reasons the country is facing times of turmoil. And it needn’t look any farther than at itself to find the answer.

Economy Minister Andrei Berlousov has warned that quarterly growth might turn negative before the year is out if the government does not intervene. He said: “We are not in a recession yet, but we could end up there.”

The state appears unable to efficiently convert oil revenues into higher growth

During an address held in Sochi – venue for the upcoming Winter Olympics – the President said: “The production decline and crisis developments in the world financial system may affect, and are actually affecting, our own economy as well as we can see, and we must be ready for this. We must be prepared for the fact that the recession and the crisis in the global financial system may affect our economy.”

Running out
Russia has cut its growth forecast for 2013 from four percent to 2.4 percent. If this turns out to be accurate, the country will only just have grown the same as last year. Putin is worried. He recently reversed his position on austerity without warning, deciding to reinstate a controversial former finance minister ousted unceremoniously by former president and current Prime Minister Dmitry Medvedev in 2011.

The shift in policy has exacerbated rumours of a rift between the president and his former protégé, the prime minister. It is not a reassuring picture, politically or economically; the last time Russia found itself with similarly disappointing growth prospects was in 2009, when it ended up contracting almost 10 percent.

Russia’s economy has coasted for years, supported by high commodity prices. Over 90 percent of the country’s exports are natural resources, so, now that oil and gas prices are lagging, the country is deflated. It has grown only 1.1 percent over the first quarter of the year, compared to four percent during the same period last year.

The economy has also been blighted by flailing demand for some of its most valuable commodities. This, in turn, has shone the spotlight on the country’s need for economic modernisation. Deputy Economy Minister Andrei Klepach recently announced the ministry would be cutting its prediction for industrial output to two percent – revised down from 3.6 percent. He added the new figures were “optimistic”.

Depardieu in, Russians out
Even if Gerard Depardieu believes Russia is the place for wealthy Europeans to be, it does not seem to be the popular opinion among the more affluent natives. It has been known for years that Russians have not invested their vast post-Soviet wealth in the fertile lands of Mother Russia.

Cyprus was a notorious destination for Russians stashing the cash: wealthy businessmen and women chose the Mediterranean island as the home for their myriad business ventures – in paper only of course – to take full advantage of the lenient tax code, while the real money was being earned and spent elsewhere.

It meant trouble for Cyprus, of course – the island’s super-inflated financial sector collapsed under its own weight – but it also means trouble for Russia. Most of the wealth once stashed in Cypriot banks was earned in Russia through government contracts, big bonuses, oil deals and so on. The fact that that money is not being spent or invested in Russia itself means it is a drain on the economy.

It has been widely reported that savvy investors pulled their money from those coffers when they smelled danger months ago. Even Cypriot Finance Minister Michael Sarris admitted there had been “substantial outflows” from the island’s banks for weeks prior to the crisis being announced.

Though many oligarchs still base their business on the Mediterranean island, the idea that Russian businesses would have suffered from the involuntary haircut in deposits is somewhat implausible. “You must be out of your mind!” Igor Zyuzin snapped at a Reuters journalist who suggested his New York-listed group Mechel might have suffered from the Cypriot financial collapse.

Deposit drain
While cultural similarities, geographical proximity and good weather made Cyprus the ideal destination for Russian cash, it is by no means the only alternative. Reports have already surfaced of key Russian players moving their investments stateside. Ed Mermelstein – a real estate lawyer in New York who advises Russian clients – told The Guardian many wealthy Russians are turning to the Big Apple.

Explaining why there had been an increase in Russian money in the city, he said: “This past year, we’ve been seeing a shift in investments in the US as a result of the financial state of the European Union. Cyprus had started having the conversations about what it was intending, and that’s been going on for
half a year.”

But a ‘deposit-drain’ is not the only reason for Russia’s faltering finances. Putin is not wrong to attribute the slowdown to weak demand from Europe. Russia is the world’s biggest energy producer, and as such it is more susceptible to investment cuts from Europe. However, Russia’s lack of adequate infrastructure and stunted financial modernisation mean weak demand and low oil prices are only a part of the puzzle.

“Russia’s economy is clearly worse off as a result of lower oil prices. After all, it is the world’s second largest oil producer and oil and gas accounts for 60 percent of total exports,” explains Neil Shearing, from Capital Economics. “We expect growth in Russia to stay extremely sluggish in the 2013-14 period and our forecasts remain well below consensus. But this is largely due to structural factors that have caused trend growth to slow, rather than to the effect of lower oil prices.”

Fiscal stimulus
Even though the Ministry of Economy has suggested it will be continuing to provide fiscal stimulus, it is by no means a permanent solution. Previous increases in spending have left the government stretched thin. The current budget will almost certainly run into a deficit, due in part to low oil prices. In order for the budget to break even in 2013, oil prices will have to rise and stay around the $110 a barrel mark – and considering barrels of crude have been selling for around $90, prospects are dim.

Though Russia is incredibly rich in natural resources, historically it has not been efficient at converting that wealth into investment. In 2009, Russia suffered from tumbling oil prices that reached a nadir of $60 a barrel before rebounding back to $110, but the country was incapable of recovering from the drop. “The state appears unable to efficiently convert oil revenues into higher growth,” says Nadia Orlova, Chief Economist at Alfa Bank. “In contrast to consumption, production growth has weakened markedly. [This] reflects reduced competitiveness.”

Orlova recently predicted government spending will drop to between two and four percent in 2013, “putting economic growth at risk. Adhering to the budget rule would be positive for macro stability but would be a drag on the economy unless the government changes its economic growth model – amending the budget rule may add to growth, but it would tarnish the state’s credibility”.

During the meeting in Sochi, the President discussed the reasons behind the slowdown with the economy ministry. The Russian economy remains a large and convoluted establishment, fraught with red tape and corruption. The country continues to battle with elevated inflation, which is contributing to the slowing of output growth. And slow growth often becomes something of a self-fulfilling prophecy; as the economy slows, investment slows too.

It is simple economic theory, but one Putin is struggling with: an increase in public or private investment spending will inevitably have a more-than-proportionate positive impact on the economy as a whole. Gazprom – the country’s largest producer of oil and gas – is owned by the state and extremely profitable. But none of the money the energy giant produces is ever reinvested in infrastructure – leaving Russia stuck.

While other countries in the increasingly prestigious BRICS club continue to attract foreign investment, it has been estimated $350bn worth of investments have left Russia over the past five years. This, in turn, means the country’s already out-dated infrastructure is suffering. The national road network has not been expanded or updated in 20 years. Klepach has also cut the forecast for investment from 6.5 percent to 4.6 percent.

No easy answer
Though the situation is still not quite as dire as Putin’s tone indicated, it is not going well in Russia. The country is relatively stable – debt is relatively low at 12 percent of GDP and there is an adequate monetary policy in place – and, soon after the Sochi meeting in early April, the Economy Ministry finally found support for its call for fiscal stimulus. It continues to aim for an extra RUB 100bn ($3.2bn) of fiscal spending in this year alone.

Conversely, the same ministry has predicted a brutal slowdown across all sectors of the economy, triggered by the lack of investment. Growth in domestic investment forecast this year has been officially lowered to 4.6 percent, from the initially predicted 7.2 percent. These are not encouraging numbers.

Consumption forecasts have also been downgraded – retail sales growth has been forecast at 4.3 percent for the year, reduced from earlier estimates of 5.4 percent growth. This is an old problem for Russia, which has often seen its most affluent citizens invest their vast wealth abroad. Spending is grinding to a halt – Russians are clutching their wallets with absolute determination.

There is no easy answer to Russia’s problems. While the global situation remains volatile, the Motherland will remain susceptible to dropping commodities prices. The lessons of 2009 teach us damage to economic growth comes not from a decline in oil prices per se, rather, lower oil prices go hand-in-hand with weaker demand for Russian exports overall.

Like other BRICS nations, Russia’s economic establishment is not efficient and it is plagued with deep-rooted malfunctions. Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington says: “The Russian economy is grinding to a halt because of too much corruption, and Putin is not prepared to face up to it.”

What Russia desperately needs – both to recover from the impending crisis and to survive future toils – is wide-ranging structural reform to support the growth of private investment competition. According to Brian Milner, a senior economics correspondent, issues will only be resolved through “a reduction of the state’s heavy handed interference, privatisation of inefficient state-controlled enterprises and an assault on endemic corruption”.

There is no easy way out of the current wave of weak growth. The best Putin and his government associates can do is start tackling the many shortcomings of their country’s economic machine. It is a tall order and it is unlikely the President will have what it takes to challenge the very business class of oligarchs he helped create, or to relinquish some of his political influence and that of his associates.